Stockholders can hold company responsible for CEO fraud

Stockholders can hold a corporation financially responsible for fraud by a chief executive, even if the company didn’t authorize it, a federal appeals court ruled Friday.

In reinstating a damage suit by shareholders of ChinaCast Educational Corp. over a multimillion-dollar swindle that destroyed the company, the Ninth U.S. Circuit Court of Appeals in San Francisco said a corporation that put an executive in a position of authority can be held to account for his or her wrongdoing against innocent third parties, regardless of whether it served corporate interests.

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Holding the company financially responsible promotes “fair risk allocation and ensuring close and careful oversight of high-ranking corporate officials to deter securities fraud,” Judge Margaret McKeown said in the 3-0 ruling.

ChinaCast, which sold long-distance learning and online multimedia education, posted a market capitalization of more than $200 million before its downfall. In their lawsuit, shareholders accused Ron Chan Tze Ngon, the company’s founder and CEO, of frauds that included transferring $120 million of corporate assets to accounts controlled by Chan and his allies between June 2011 and April 2012.

Chan and ChinaCast’s chief financial officer assured investors in 2011 that the company was sound. But after discovering that Chan had tried to interfere with an audit, the board of directors removed him as CEO in March 2012. The Securities and Exchange Commission sued Chan in 2013 and obtained a judgment in federal court in January of this year requiring Chan to repay nearly $43 million in ill-gotten gains, interest and penalties, and barring Chan, a Chinese citizen, from the U.S. securities industry.

The suit by investors who bought stock in 2011 and early 2012 was initially dismissed by U.S. District Judge John Walter of Los Angeles, on the grounds that employers are responsible only for actions their employees take in the normal course of their employment, and not for actions against the employers’ interests. But the appeals court said the normal rule doesn’t apply to suits by innocent shareholders who rely on an executive’s authority to act in the name of the company.

As CEO, Chan was “the one person on whom the board undoubtedly should have kept close tabs,” McKeown said in Friday’s ruling. Based on the allegations in the suit, she said, closer oversight might have prevented “much of the decimation of ChinaCast’s bottom line and share value.”

Marc Gross, a lawyer for the stockholders, said the ruling is one of the first of its kind on the issue and should send a message to courts around the nation.

“Corporations are the ones who select CEOs to run the company,” Gross said. “Investors under those circumstances should not be the ones holding the bag.”